1st Quarter 2006: 2005 - A Year of Transition

First Quarter 2006
Market Commentary

"2005 - A Year of Transition"

Now that 2005 has drawn to a close, and we enter a New Year, we thought it might be helpful to review some of the major events of 2005, as to where these events might take us in 2006.

To begin, we view 2005 as a year of transition. Major events occurring in 2005 were a continuation of the war in Iraq, natural disasters, the rising price of oil and its impact on the economy, and finally - the economy itself.

A. Iraq

What happens in Iraq will be of momentous impact. With the recent election, our hope is that we now have the possibility of major change in the Mid East.

Despite the fact that we have lost over 2,000 soldiers in Iraq, we may have reached a point where we have hopefully trained enough Iraqis to maintain law and order in hopes that it might evolve into a market oriented economy, rather than unravel into a radical militant Islamic state.

Indeed, Iraq will continue to be a major drag on our collective psyche; yet the changes there may well begin to give us hope for improvement, and quite possibly begin to see our soldiers returning home. If so, the market will probably respond to these changes favorably; certainly any change in perception would turn a major negative into something less damaging.

B. Natural Disasters

Hurricanes Katrina and Rita left millions homeless and New Orleans and much of the Gulf Coast devastated. The double hurricane knocked out close to 20% of the refining capacity of the U.S. and temporarily shut down the port of New Orleans, which handles close to half of the imported oil coming into the U.S. Most analysts responded to the above named hurricanes by immediately lowering economic forecasts, and ratcheting up cost estimates for its remediation and repair. In fact, economists jumped on this by predicting that the high price of gasoline will not only slow the economy, but quite possibly lead to a recession; given the pervasive requirement for energy in just about everything we produce.

C. Oil

Our view is that the price of oil will remain high, and that it will become embedded in higher prices for goods and services across the board. China, which was a net exporter of oil just a few years ago, is now the 2nd biggest importer - next to the U.S, and it shows no signs of slowing down. Likewise, India has ratcheted up its usage of Oil, and both countries are busily engaged in building out their infrastructure.

2005 saw the price of oil jump from $30.00 in March to a high of $70.00 in October after the aforementioned hurricanes struck. Likewise, the price of gasoline briefly hit over $3.00 per gallon in various parts of the country, and now still runs close to $2.50 per gallon, even as production has ramped back up.

Currently, the price of Oil hovers near $66 per barrel, and in our view, may be headed higher still. We say this because:
a) Previous peaks in the price of oil have largely been created by a curtailment of supply, whereas this price peak is largely demand driven.
b) The chart below shows an inflation adjusted price of oil which shows:
8888 1) The Arab Oil Embargo of 1979 (wherein oil was withheld for political reasons).
8888 2) The last oil run-up in the early 90's when the industry was looking at the possibility of $50 oil. This occurred 8888during the first Gulf war because of the fear of reduced supply.

Inflation Adjusted Monthly Crude Oil Prices (1946 - Present) In September 2005 Dollars


Today's price hike is being driven by a worldwide demand for oil; particularly from emerging nations anxious to enter the global economy. Small incremental changes in demand at the margin can lead to big price increases. This is particularly true when one considers that worldwide production of oil is approximately 82 million barrels of oil per day, and consumption is approximately 81 million barrels of oil per day. It doesn't leave a lot of room for error.
Add to that the fact that the fourth largest oil producer in the world is Iran; and Iran has threatened to shut off their oil production for export if the pressures from the United States and the European Union to stop their nuclear programs persist. It's highly probable that both the United States and Europe will force the United Nations (UN) Security Council to get involved in this matter; it's also highly probable that the UN will do nothing about it, a la Iraq.

Meanwhile, Royal Dutch Shell declared Force Majeure on a major field in Nigeria, amidst threats of attacks on Nigeria's oil industry. Nigeria is the world's 11th largest oil producer. Shell's field in question produces 115,000 barrels per day and Shell is responding to Nigerian militants who already have sabotaged oil facilities in the area.

The emergence of Hugo Chavez in Venezuela, a known communist and confidant of Fidel Castro, is also problematic. Venezuela has become a major supplier to the United States; yet even as this is being written, Chavez is trying to expropriate ownership of major facilities owned by Exxon in that country.

D. Home Building/Real Estate

In our 3rd Quarter Commentary , we voiced our concerns - not about home building per se, which has been a red-hot sector in the past two years; but rather about what we see as very extended pricing in the residential real estate market.

We further commented that the commercial banks have essentially become mortgage brokers, and they and other mortgage brokers have become somewhat careless in the quality of their lending procedures. We say this largely because they securitize practically all-residential loans, and sell packages of mortgages to Fannie Mae and Freddie Mac, both quasi government agencies who assume the risk of borrower defaults if the underlying collateral falls in value. We are still very concerned about this for the following reasons:
a) We believe that there is a strong link between consumer spending, and the recent (1-5 year) build up of equity values in one's home . Our third quarter report commented that $223 billion had been borrowed against home equity over the previous year (2004), and that approximately half of this money showed up in increased spending by consumers. As such, we feel that many consumers have been tapping into their home equity for some spending money. Thus, if the values of residential real estate start to fall - and there is evidence this is already beginning to occur, then the direction of consumer spending, which is 2/3 of the economy, may stall as well.
b) Further, the home building industry referred to above has become the largest employer in the U.S., and the construction industry has become the largest driver of new jobs. If consumer spending starts tilting downward, we could see home construction slowing, and the concerns of our last commentary "Slowdown In Sight" begin to manifest itself.
(Question). What could cause this sequence of events to occur?

(Answer) The Federal Reserve Bank - Alan Greenspan, chairman of the Federal Reserve Bank, has continued raising interest rates, for the 14th consecutive Federal Reserve open market meeting. Beginning in June 04' with a 1% (Federal Funds overnight rate), - this rate now propelled to 4 ½ %.

The emergence of Ben Bernanke, currently Chairman of The Presidents Council of Economic Advisors, and previously President of The Dallas Federal Reserve Bank, as a replacement to Alan Greenspan, has been well received by market participants. Nonetheless, he has a tough job ahead, and past speeches by Mr. Bernanke would indicate he is well aware of the sensitivity of the economy to interest rate hikes. The Federal Reserve has historically gone too far in raising interest rates, after pushing the economy to a breaking point and recession. Our view is that this may not happen this time, here's why -

E. The Economy

The irony of what's happening in the economy is that the problems discussed above, which appear to be serious negatives, have turned into short-term positives.

For example, the devastation of the hurricanes in the Gulf Coast have prompted expenditures of hundreds of billions of dollars to rebuild and improve the area, with billions of private money complimenting large expenditures by the Federal Government. These expenditures have a rippling and multiplying effect economically, at least in the short term. The borrowings used by the government to finance their share of it, however, will ultimately be tacked onto our budget deficit short term, and our national debt long term. Our estimate is that this federal expenditure could reach $300 billion.

Having said that, the strength of our economy has generated tax revenues significantly higher than previously estimated, both nationally and in California. (Governor Schwarzeneggar has used this windfall to ask for $225 billion of new spending, but that's another story for another day.)

The Federal Government, however, reported a fiscal year end September 2005 deficit of $319 billion, just 2.6% of GDP, in line with average deficits going back 35 years (see chart below). Any deficit creates a problem, to be sure. But the risk of the budget deficit spinning out of control is probably not warranted. Estimates by the Congressional Budget Office expect a deficit of $400 billion in 2006, largely due to hurricane recovery efforts and the war in Iraq .


Moreover, corporate America has now manifested itself with a 14th consecutive quarter of double digit profit gains. Third quarter S&P earnings for 2005 came in at 11.5% over year. Perhaps more impressive is that if one strips out energy company profits from the above figure, S&P 500 earnings were up 9.6% for the last quarter .

Further, we've now had 10 successive quarters of economic growth - averaging close to 4%, and stretching back to mid - 2003. The United States economy grew 3.8% in the third quarter, and despite the initial effects of Katrina and Rita, should still be close to over 3% in the fourth quarter of 2005.

Looking into 2006, GDP growth estimates average around 3.4% , although there is a wide disparity from the mean. Nonetheless, we see 3.4% GDP growth as quite viable; and if so, should be strong enough to keep momentum continuing throughout coming months, yet low enough to warrant a slow down in the pace of interest rate hikes. (Which would cause the market to rise).

F. The Market

So while 2005 proved to be a year in transition, one could argue that the past six years have all been years of transition. The popular DOW and S&P averages have made little progress during this time, (see chart below) and the NASDAQ is still well below its 2000 peak. Since December 31, 1999 to the end of 2005, the Dow was down 1%, NASDAQ down 33%, and the S&P down 10%.


Under the surface, however, corporate earnings have gone up steadily during this time, while P/E (price/earnings) ratios have gone steadily down, and actual prices, while volatile, remained basically flat.

In addition, corporations are raising dividends at a record rate, and so our theme of buying strong companies with rising dividends remains valid - particularly as more investors approach retirement. Further, corporate stock buy-back programs are also accelerating at a high rate. The combination of these factors give us the sense that sooner or later there will be a "return to the mean," wherein earnings keep rising - price/earnings relationships stay constant and/or improve, with the outcome leading to higher prices.

As we move forward into 2006, we intend to expand upon the events listed above, and how they interact with the growing forces of Globalism, international trade, and our growing trade deficit.

Once again, thanks for your support. Please call us with any questions you might have and we hope you have a Happy New Year.

Bill Schnieders

Jim Schnieders, CFA

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